Eli Dourado

Monetary confusion

Scott Sumner has drawn a lot of attention for his peculiar view that monetary policy was tight in 2008, and that this tightness was the cause of the current recession and the recent financial crisis. I think his argument is at least somewhat persuasive; I don’t know if (or think that) it was the whole problem, but it does seem to me that his monetary proposal would have at least decreased the severity of the recession.

What intrigues me, however, are the implications Sumner’s view has for macro and monetary theory. Sumner is arguing that monetary policy was tight in 2008, while most other economists would argue that it was loose. In a recent post, Sumner suggests that there is no persusasive metric of monetary stance. Nominal interest rates can signal monetary stance or inflation expectations. Real interest rates were high in late 2008, but most economists think monetary policy was loose. Other indicators have their own problems.

If even economists disagree about whether money is tight or loose, what hope do ordinary producers and consumers have of preemptively adjusting to monetary policy? If people are genuinely confused about the stance of the monetary authority, this breathes new life into a class of economic models that the profession has discarded and ignored in recent decades, epitomized by the Lucas-Islands model. In the Lucas story, as I remember it, producers observe changes in demand for their products and change their production, factoring in all expected changes in inflation. If inflation is expected, then producers who observe increased demand for their products won’t be tricked into increasing production—they will realize that only nominal, and not real, demand has increased. If inflation is unexpected, producers will think the observed increase in demand is real, not just nominal, and increase production accordingly. The model therefore establishes a link between unanticipated inflation and the real economy.

The Lucas-Islands model has fallen out of favor because of the simple criticism that it is trivially possible to observe the open-market operations of central banks. On any given day, it is easy to determine, say, the monetary base, or whether the Fed is buying or selling treasuries. Therefore, the story goes, no inflation should be unanticipated. Yet we observe in reality that monetary policy seems to have an effect on the real economy; therefore the Lucas model cannot be correct.

If, however, the actions of the central bank are not sufficient to determine the monetary stance, the Lucas model (or other monetary confusion models) could still be accurate. One would have to assume that errors are clustered, but that is compatible with rational expectations. Throw in heterogeneous K and you are most of the way to Austrian business cycle theory. The logical conclusion is that economists ought to reexamine these macro models or incorporate monetary confusion into newer DSGE models (although they might then have to be renamed DSG_D_ models). Unless someone is able to convince Sumner that monetary policy was loose in 2008 after all, it seems that taking monetary confusion more seriously is a promising way forward for macro.